It is astonishing to me how the carnage in the stock market this past week was completely misrepresented and misattributed to the debt downgrade by the S&P. There is a critical distinction that is being missed by the pundits on CNBC and other business networks. The reaction of the stock market earlier this week was NOT due to the concerns about the US solvency but more about the economy’s poor growth-prospects.
Just to recap a bit: S&P downgraded the US bond rating- raising doubts about the credit worthiness of the country. However, rather than shedding US bonds, investors are crowding into US debt. This sudden rise in the appetite for the US debt has drove down the 10-year treasury interest rate to 2.24 percent (the higher the demand for bonds, the lower the interest rates on them). This indicates the markets’ complete repudiation of the diagnosis offered by the S&P. For the investors, the US remains a safe haven for their investments.
So, the real worry in the market is not the US’s inability to service and payoff its debt, but rather the pockets of stress that remain in the economy. The shortfalls in private investment and aggregate demand, anemic job-growth, stress in the housing market, etc. continue to impair the growth potential of the economy. Until we successfully ameliorate these problems, the stock market would remain volatile and extremely sensitive to the news headlines.
So, why is the US 10-year rate at a record low despite the downgrade? One word: Europe. The sovereign debt contagion has spread from the periphery economies like Greece, Portugal, etc. to major economies like Italy and Spain. Above are the 10-year rates on Italian and Spanish bonds. Both are hovering between 4.99 to 5.2 percent. These problems in Europe have forced the investors to pull their savings out from the EU and pile into the US bonds. So, thanks to the tepid steps taken by the European Central Bank and Brussels, the US debt continues to retain its status as the safest security to invest in.
NOTE: A 10-year bond rate above (>) 5 percent signals impending debt crisis leading to a possible speculative attack.